Crypto Predictions 2019: The Legal Landscape – Expect Enforcement

While the cryptocurrency and blockchain industry reels from a financially punishing 2018, it is likely that 2019 will be equally grueling, as a wave of enforcement actions break over the sector—and specifically on many of 2017 and 2018’s most successful Initial Coin Offerings and the crypto exchanges that trade their tokens

Now just over a year old, the SEC’s specialist Cyber Unit has ramped up its enforcement actions in recent months. In a statement issued in November, the agency put this enforcement in context, explaining the motivation behind recent action, and setting a precedent for enforcement in 2019.

In short, it appears the SEC’s scrutiny of the cryptocurrency sector is now moving beyond participants the Commission views as intentional bad actors, as in U.S. v. Zaslavskiy, for example, and on to those who might best be described as cavalier or negligent in their attitude as to whether U.S securities laws applied to them.

Two recent SEC enforcement orders illustrate that the target has now shifted from intentional fraudsters, to the Initial Coin Offering (ICO) model itself. Airfox and Paragon were two ICO-funded projects that raised millions in late 2017. After being charged with illegally selling securities and failing to register with the SEC, both settled with the Commission in November.

As both organizations touted practical use cases for the tokens in their respective projects, the enforcement action is a vindication for those who warned that claims of ‘utility token’ status, or promises of future functionality, would be a flimsy defense against securities law actions. With little to distinguish Paragon and Airfox from a raft of other ICOs, enforcement against other projects now seems inevitable.

It is noteworthy that both the Airfox and Paragon ICOs occurred after the SEC published its ‘Dao Report’ on July 27, 2017. In this report, the Commission warned issuers of digital tokens that they had to register "offers and sales of such securities unless a valid exemption applies." Proceedings against Airfox and Paragon were both brought pursuant to Section 8A of the 1933 Securities Act, which permits the Commission to enter an order against any person who "knew or should have known" their actions would contribute to a violation of the Act.

Implicit in the actions against Airfox and Paragon, therefore, is that the Commission views July 27, 2017, as the date from which any ICO issuer ‘should have known’ its project was likely to be in breach of securities laws. Thus, any ICO project launched after that date for which no valid exemption from US securities law exists, will likely be a target for an SEC enforcement action in due course.

The SEC has described the Airfox and Paragon settlements as a model for how organizations that have already conducted ICOs can seek to retroactively comply with federal securities laws. Amongst other things, such compliance will require the payment of fines, that all funds raised are returned to their investors, and that tokens be registered as securities. In all, approximately $24 billion has been raised in ICO events conducted since July 2017. With the US being identified as a ‘ICO Hub‘ by PWC, it is reasonable to assume that a significant percentage of these raises targeted and secured US investors.

One unique aspect of ICO fundraising to date has been that issuers typically sought Bitcoin or Ethereum in exchange for project tokens, as opposed to a fiat currency like US dollars. In their settlements with the Commission, Airfox and Paragon agreed to comply with section 12(a) of the Securities Act which states that investors are entitled to "recover the consideration paid for such security with interest thereon … or for damages if he no longer owns the security." On its face, this section appears favorable to the respondent ICOs, as the price of Bitcoin and Ethereum is currently down by approximately 90 percent from its 2017 highs—and returning Bitcoin or Ethereum to investors today would be less economically burdensome.

However, in its claim notification to investors, Airfox has stated it will refund claimants in US dollars based on the US dollar value of their investment at the time of purchase. As most ICO projects had no significant funds prior to their raises, and any raises held in Bitcoin or Ethereum have lost approximately 90 percent of their value during 2018, it is difficult to see how this route to compliance would be financially viable for many ICOs caught in this net. Further compounding this issue is the fact that most ICOs have not produced a working product yet, which could make additional capital raising challenging.

Also noteworthy for 2019 is that the statute of limitations (section 13 of the Act) relating to bringing an action pursuant to the Securities Act, allows no action "unless brought within one year after the discovery of the untrue statement or the omission, or after such discovery should have been made by the exercise of reasonable diligence." For many investors, this window of opportunity will close sometime in 2019, but before it does we may see more cases like the class action lawsuit filed in California by David Oconer against Ripple Labs and a similar New Jersey suit, Solis v. Latium Network.

From the SEC and FinCEN, to the CFTC and the Treasury, numerous government agencies announced that crypto exchange platforms were on their radar during 2018. In early fall the SEC brought a case against 1Broker and its CEO Patrick Brunner—alleging that it was not registered as a "security-based swaps dealer" and "failed to transact its security-based swaps on a registered national exchange."

The case was particularly interesting because Brunner is an Austrian national, and his exchange was operating in the Marshall Islands. Nonetheless, the 1Broker website was seized and closed by the FBI on September 27. It has since reopened, but only to allow withdrawals. In a statement confirming its closure, iBroker stated: "the last weeks have shown that a strict regulatory framework for cryptocurrency-related platforms is on the horizon and that it will be enforced across borders."

On November 8 the SEC announced it had charged EtherDelta founder Zachary Coburn with operating "an unregistered national securities exchange." Coburn settled the case, agreeing to pay $300,000 in disgorgement and a $75,000 penalty. Interestingly, in its statement on the matter, the SEC again referred to the fact that most of the trading on EtherDelta had occurred after the release of its Dao Report—in essence confirming July 27, 2017, as the cut-off date for any expectation of a laissez-faire approach to enforcement.

As recently as November 26, SEC Jay Clayton confirmed the Commission’s ‘get registered’ position on exchanges, telling an audience at Consensus Invest in New York that when there was a platform facilitating open public trading of securities through a matching of buyers and sellers, then such an organization "must be registered as an exchange." Despite this, however, no crypto exchanges currently appear on the SEC’s list of active National Securities Exchanges.

An often-repeated phrase concerning the entry of institutional money into the crypto sector is that investors are waiting for ‘regulatory clarity’ before moving. It is certainly arguable that the unequivocal and repeated warnings from the SEC and others, followed by the enforcement actions of 2018 have provided all the clarity anyone could ask for. ICO ventures past, present and future should assume that tokens issued to fund the venture are securities and approach their legal position accordingly. Similarly, any organization that facilitates public trading of these tokens should apply for registration.

Not mentioned in this article but equally likely to feature prominently on 2018’s legal landscape will be a ramping up of crypto related prosecutions under anti-money laundering statutes such as 18 U.S.C. § 1956 in the US, and the European Union’s recently enacted fifth money laundering directive (MLD5).

As crypto climbs out of the regulatory sandbox and into a new era of enforcement, strategic prosecutions by the SEC and other enforcement agencies can be expected to continue, until all sectors of the crypto industry have been drawn into compliance.